Singapore Property Sector - A Switch From Defensive To Growth

Following our observations on developments in the macroeconomic landscape and conclusions drawn from the 4QCY17 earnings season, we reaffirm our positive view on Singapore developers over S-REITs.

The thesis of this report is to recommend investors to skew their real estate equity portfolio bias towards Singapore developers, or in other words, to reallocate capital and switch out of S-REITs to developers.

Our preference for Singapore developers are premised on the following three key themes:

We are sanguine on the operational and earnings outlook of major Singapore developers with significant Singapore residential exposure and/or strong recurring income streams from diversified investment properties. We believe the Singapore residential market has now entered a nascent stage of a potential multi-year recovery, amid a firm economic backdrop and improving buyer sentiment.

Although S-REITs will also be able to benefit from a stronger economic outlook, we believe the impact will not be as pronounced as developers, given that rental leases are typically locked in for 3-5 years. Furthermore, most REIT Managers have previously sought to limit downside risks for their unitholders by placing stronger emphasis on forward renewing their leases to lock in the occupancy levels, hence missing out on potentially higher rental rates in the near future to a certain extent.

Historically, the share price performance of the FSTREH has a relatively high correlation of 0.72 with changes in the URA Private Residential Price Index.

Looking ahead, we forecast Singapore residential prices to increase 3% - 8% in 2018, and also project private primary sales transaction volume in the range of 12k-15k this year. We expect this to be one key catalyst for Singapore developers.

Theme 2: Share prices of developers have outperformed S-REITs during the last major rate hike cycle and current ongoing one

Although the share prices of S-REITs and Singapore developers performed well during the last major rate hike cycle from Jun 2004 to Jun 2006 and the current ongoing cycle since Dec 2016, we note that developers outperformed S-REITs on both occasions.

During the period from Jun 2004-Jun 2006, the FSTREH rose a whopping 110.3%, while the FSTREI increased 25.8%. From 14 Dec 2016 (when the Fed first raised the Fed funds rate under this ongoing cycle) till now, the FSTREH and FSTREI increased 23.8% and 12.8%, respectively. We expect this trend to continue.

Domestic benchmark rates for mortgages (SIBOR/SOR) are projected to increase as most major Central Banks continue their policy tightening stance. According to Bloomberg consensus’ average forecasts, economists are expecting the 3M SIBOR to hit 1.78% and 2.17% by end-2018 and end-2019, respectively. To put things in perspective, the 3M SIBOR was 1.50% as at end-2017, and last stood at 1.38%. Rising rates will likely partially offset fundamental tailwinds but we believe the overall impact is still manageable for developers and homeowners.

As an illustration, if the 3M SIBOR rises by 125 bps to 2.63%, we estimate that the monthly mortgage payments for an owner of a second home in Singapore worth $1m will increase from ~S$2.2k to S$2.6k, under a 60% LTV ratio and 30-year loan tenor assumption. This is unlikely to create a significant increase in financial strain for the homeowner. For investment home owners, the anticipated recovery in housing rentals ahead will also help to alleviate the pressure on rental carry from higher rates.

Theme 3: Developers still trading significantly below their 10- year average P/B but S-REITs are trading at a premium

Despite a more robust outlook for developers as compared to S-REITs, the FSTREH is still trading at a large discount to NAV and also against historical averages.

We note that during property bull-cycles, developers have traded at a premium to their NAV. For example, during the last upcycle in 2010, the forward P/B ratio of the FTSE ST Real Estate Holding and Development Index (FSTREH) reached a peak of 1.13x, while the current forward P/B ratio stands at 0.69x, or 0.7 SD below the 10-year average. We thus see room for further re-rating in the sector, and expect the discount gap to narrow as residential prices continue its upward trajectory.

On the contrary, the S-REITs sector is trading at relatively unattractive valuations, with a forward P/B ratio of 1.04x, or 0.7 SD above its 10-year mean. We take our analysis further by examining the P/B spread between the FSTREH against the FSTREI. We note that the current spread (FSTREH - FSTREI) is -0.35, which is 1.3 SD below the 10-year average of -0.14.

We conclude that developers offer a more attractive risk-reward proposition than S-REITs.

We are OVERWEIGHT the Singapore property sector, with a positive bias towards the residential sector.

Our preferred picks are City Developments Limited [Rating: BUY, Fair Value: S$15.91], UOL Group Limited [Rating: BUY, Fair Value: S$10.63] and CapitaLand Limited [Rating: BUY, Fair Value: S$4.26], which are trading at attractive discounts of 37.0%, 34.2% and 28.1% to our RNAV estimates, respectively. All three also bumped up their final DPS during their recent FY17 results announcement.

The FSTREI is currently trading at a forward yield spread of 353 bps against the Singapore government 10-year bond yield. This comes in at ~1.5 SD below the 5-year average of 412 bps. Federal Reserve Governor Lael Brainard, one of the Fed’s most dovish members, highlighted that economic tailwinds may speed up the pace of rate hikes ahead. There has been an increasing probability that there would be four rate hikes this year since new Fed Chairperson Jerome Powell delivered his congressional testimony in late Feb.

We explore a scenario whereby REIT sector valuations normalise to historical average levels. Assuming a target yield spread of 412 bps which is the 5-year average, and applying a 1.9% DPU growth rate which is our average forecast for the S-REITs under coverage, this works out to a potential ~12.6% capital downside on the sector.

This more than outweighs the 6.0% expected forward distribution yield of the FSTREI. However, whether this scenario materialises would depend on a variety of factors, including upcoming inflation data points and consequently actions undertaken by the Fed as well as the liquidity in the markets.

On a standalone basis, we are positive on Singapore developers for the following key reasons:

We believe the Singapore residential market reached a nadir in 2017, and is currently at a nascent stage of recovery which is sustainable, barring any unforeseen circumstances. As a recap, the URA Private Residential Properties Price Index (PPI) reached an inflection point in 3Q17, climbing 0.7% q-o-q after 15 consecutive quarters of price decline, or a cumulative 11.6% dip from the last peak in 3Q13. This momentum continued in 4Q17, with the URA Private Residential PPI rising 0.8% q-o-q, such that the year 2017 ended in positive territory (+1.1% from 2016).

In terms of sub-markets, landed home prices fell 0.5% in 2017, while prices of non-landed properties rebounded 1.3%. The Rest of Central Region (RCR) saw a price increase of 1.8%, while the Outside Central Region (OCR) and Core Central Region (CCR) also registered growth of 1.4% and 0.6%, respectively, in 2017. Total transaction volumes (new units sold by developers excluding ECs) jumped 32.5% to 10,566 units in 2017, but still significantly below the last peak in 2012 (22,197 units).

As further evidence that buying sentiments in the market has improved, we note that there were a number of notable transactions in the highend segment. For example, City Developments Limited’s (CDL) freehold New Futura project at Leonie Hill Road saw 48 units sold (75% out of the 64 units launched) at an average selling price of over S$3,200 psf (as of 22 Feb 2018). Gramercy Park, another freehold project in the Orchard Road vicinity (Grange Road), is now 97% sold with achieved ASP in excess of S$2,800 psf.

Manageable upcoming supply in the near future

On the supply front, there were 36,029 and 6,144 uncompleted private residential units (excluding ECs) and EC units in the pipeline with planning approvals, as at 31 Dec 2017, implying a total of 42,173 units.

Of these, 18,891 remained unsold for the former, and 864 units were unsold for the latter. The 18,891 unsold units represented an increase of 17.8% q-o-q, but we believe this is not a reflection of weaker demand in the market as 76.8% of the unsold units have yet to meet the prerequisites for sales. Furthermore, the total unsold pipeline of 20,794 completed and uncompleted units is significantly below the long-term average of 32.5k units since 3Q06.

However, we are cognisant that there is also a potential pipeline of 19.9k units (including ECs) from Government Land Sales (~7.8k) and awarded en-bloc sale sites (~12.1k), according to URA.

Given the effectiveness of the Singapore government’s property cooling measures, residential prices in the city-state declined 11.6% from its last peak in 3Q13 before bottoming-out in 3Q17, as highlighted earlier. On the contrary, property prices in other key gateway cities such as Hong Kong, Sydney, New York have largely continued on an upward trajectory during the same period.

Based on the annual Demographia International Housing Affordability Survey, the cost-to-income multiple (as calculated by the median house price divided by the median household income) was 4.8x for Singapore, unchanged from 2016 and lower than the 7.3x figure in 2010. This compares favourably against the likes of Hong Kong (19.4x), Sydney (12.9x), Melbourne (9.9x), San Francisco (9.1x) and London (8.5x). For Hong Kong, Melbourne and Sydney, housing affordability actually worsened in 2017 as compared to 2016. Out of these cities highlighted, Singapore was the one which saw its housing affordability multiple improve from 2010 to 2017.

In addition, we see fewer risks in the Singapore market as the amount of speculative activities have receded over the years, based on the number of sub-sales transactions tracked. To illustrate, there was an average of 3,108 sub-sale transactions between 2009 and 2012. However, in 2017, only 367 sub-sale units changed hands in the marketplace.

Foreign buying activity has room for improvement and may surprise on the upside

Based on our argument that Singapore residential properties offers compelling relative value versus other major global cities, coupled with continued economic and income growth in the region, we believe there is room for foreign buying activity to gain traction ahead.

Although the stringent Additional Buyer Stamp Duty (ABSD) measure of 15% on foreigners remains in place, we believe this appear less onerous relative to other peer cities such as Hong Kong and China, which carry the possibility of furthering tightening measures. In Singapore, for all residential transactions completed in 2017, only 5.2% were contributed by foreigners, a far cry from the average of 8.1% since 2009 and last peak of 15.6% in 2011. Similarly, if we look at 2017 transactions for the CCR segment, 12.1% were attributed to foreigners, versus 27.3% in 2011 and average of 16.3% from 2009-2017.

For the first two months of 2018, we see some encouraging signs given that the proportion of foreigner transactions has increased to 6.6%. However, we acknowledge that the sample size is small, as two months of data is not representative of the remaining year ahead, while there were also attractive projects such as City Developments’s New Futura, which sits on freehold land. Freehold assets have historically found flavour amongst foreigners.

Sizzling en-bloc market in 2017; momentum has spilled over to 2018

The red-hot en-bloc market first saw an acceleration in momentum in May 2017, and eventually translated into a colossus ~S$8.6b of collective sales being announced (including projects which have reached an agreement but yet to obtain final regulatory approvals) last year.

We expect this to have a strong trickle-down effect on housing demand in the near-future as home sellers who are flushed with cash and borrowing headroom would likely seek to purchase replacement homes instead of renting given market expectations of rising property prices ahead.

Although the en-bloc ‘fever’ started showing some signs of fatigue since Dec, given a number of failed tender attempts, we believe momentum has started to pick up again, while the robust transactions concluded in 2017 would also be sufficient to fuel demand in the near-term for residential homes. YTD, a sizeable ~S$4.2b in en-bloc deals have been announced, although only City Towers (S$401.9m; 13% above reserve price; land price of S$1,847 psf ppr;) in Bukit Timah Road has been officially registered in URA’s database (as at 8 Mar 2018).

Looking ahead, developers would typically launch the en-bloc sites for sale approximately 1-2 years after the transaction. Although there would likely be more units available for sale post redevelopment, the average unit size tends to be smaller and hence would fetch a higher ASP on a psf basis. We believe this has two implications:

absolute price quantum of smaller units would cater to a wider target group;

higher ASP psf may lift property valuations in the vicinity.

What are some of the potential risk factors for the residential sector?

We believe government measures in Singapore over recent years have been more punitive towards developers and more supportive towards SREITs. This is not surprising given that the Singapore government is aiming to reinforce the nation’s position as a REITs hub in the region, while also seeking to keep home prices sustainable over the longer-term as there are political ramifications if the housing market is overheated.

Some of the key measures introduced in the past and still in place are the ABSD, Qualifying Certificate (QC) extension charges and Total Debt Servicing Ratio (TDSR) limit.

During Budget 2018, the top marginal Buyer’s Stamp Duty (BSD) rate for residential properties was surprisingly bumped up from 3% to 4%. This would be applied only to the portion of the residential property value which is in excess of S$1m and has already come into effect on 20 Feb 2018. Previously, the BSD was 1% for the first S$180k, 2% for the next S$180k and 3% for the remaining value of the residential property.

We believe the incremental outlay is unlikely to severely dampen demand for the residential market end users. However, there would likely be a more significant impact on the collective sales market which is larger in ticket sizes. Hence, one key risk to the residential sector is the potential introduction of further property tightening measures if home prices increase at a faster pace than the government’s expectations.

Another risk stems from the relatively high land bids paid for both GLS and collective sales as land-hungry developers compete aggressively to replenish their depleting land banks. This may lead to tighter profit margins and leaves developers more vulnerable in the event that an economic downturn hits, or if selling prices fail to materialise in accordance to developers’ expectations.

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